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16 Cryptocurrency Facts You Should Know

With virtual currencies all the rage, here are the pertinent facts you should know before you invest.

Historically, no asset has been a greater creator of long-term wealth than the stock market. Over time, stocks have generated a 7% annualized return, inclusive of dividend reinvestment and adjusted for inflation. This suggests an investor could double their money about once every decade, which is pretty impressive.

However, cryptocurrencies -- digital currencies that utilize encryption to generate money and verify transactions -- have left the stock market in the dust since the year began. Virtual currency investors have, in many instances, seen a lifetime's worth of gains over the course of 11 months.

But before you consider diving into the cryptocurrency craze, here are 16 facts you should know.

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1. Digital currencies are exceptionally volatile

Probably the first thing you'll notice if you've been following cryptocurrencies is that they're exceptionally volatile. This derives from the fact that virtual currency trading occurs on various cryptocurrency exchanges rather than a central exchange, leading to increased volatility.

Since the year began, the aggregate market cap of all cryptocurrencies combined has increased by more than 3,200% as of Dec. 18. Nonetheless, bitcoin, the world's most popular cryptocurrency, has undergone four corrections of at least 20% over the past six months. In short, cryptocurrencies aren't for the faint of heart.

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2. Cryptocurrencies have no fundamental backing

They also have no tangible fundamental factors with which to help derive an appropriate valuation. Whereas you can look at the earnings history of a publicly trading stock to estimate its worth, or the economic performance of a country with regard to GDP growth to value a currency like the dollar, digital currencies have no direct fundamental ties. This makes valuing cryptocurrencies in a traditional sense especially difficult, if not impossible.

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3. There are more than 1,300 cryptocurrencies (but bitcoin is king)

If you've been following the appreciation of virtual currencies, you've probably heard an awful lot about bitcoin -- and with good reason. It was the first tradable cryptocurrency that was brought to market, and it currently makes up 54% of the aggregate $589 billion market cap of all cryptocurrencies.

However, it's far from alone. There are more than 1,300 other virtual currencies that investors can buy, of which over two dozen have a market cap that's in excess of $1 billion.

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4. Blockchain is where the real value lies

Despite the emphasis on trading virtual currencies, it's actually what underlies cryptocurrencies that could be particularly valuable.

Blockchain technology is the infrastructure that cryptocurrencies like bitcoin are founded on. It's a digital and decentralized ledger that records payment and transfer transactions in a safe and efficient manner. It's also the big reason why big businesses are so excited.

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5. "Miners" play a critical role

However, cryptocurrency transactions need to be verified, and the blockchain regularly enlarged, to account for new transactions and payments. This job falls to a group of folks known as cryptocurrency miners.

Crypto-mining involves using high-powered computers to solve complex mathematical equations on a competitive basis in order to verify and log transactions. Being the first to do so often entitles the miner to a reward, which is given in the form of cryptocurrency coins and/or transaction fees associated with a block. Though the hardware and electricity costs can be enormous, mining can also be extremely rewarding. The graphics-card hardware needs of miners has been a big reason why NVIDIA and Advanced Micro Devices have seen a double-digit percentage surge in sales recently.

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6. Decentralization is key

What makes blockchain technology so enticing is the fact that it's decentralized. In other words, there is no central hub where this information is stored, and therefore no major data center where cybercriminals can attack and gain control of a particular digital currency.

Instead, servers and hard drives across the globe contain bits and pieces of information about a particular blockchain network, but not enough to cripple it should the data inside fall into the wrong hands. This makes blockchain a particularly secure technology, which is appealing to big businesses.

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7. Blockchain has numerous other advantages

But there's more to like about blockchain technology than just its decentralization. Because miners are working 24 hours a day and seven days a week to verify transactions, they can be settled much quicker than through traditional banking, which sticks to normal businesses hours, closes for the weekends, and often holds funds for a few days. Plus, without a middleman, transaction costs can actually go down with blockchain.

Additionally, blockchain offers user control and transparency. Rather than letting a third-party control the future of a cryptocurrencies' blockchain, members of a cryptocurrencies' community are who call the shots with regard to future development.

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8. But blockchain isn't perfect, either

Then again, blockchain does have its drawbacks. For instance, it's a nascent technology that's still being developed, meaning it's bound to hit bumps in the road. These bumps can include transaction speed and verification slowdowns, which are critical advantages that enterprises will be looking for if they switch away from the traditional databases currently in use.

There are also worries about integrating this new technology into the fold. While it could allow for quicker cross-border transactions and added security for the financial services industry, there's no guarantee of a quick transition to blockchain.

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9. Blockchain technology is being tested by a number of brand-name businesses

Despite these disadvantages, few would argue that blockchain isn't a potentially game-changing technology. A number of big businesses have partnered with cryptocurrency-backed blockchains in small-scale and pilot projects.

For instance, 200 organizations have joined the Enterprise Ethereum Alliance to test out a version of Ethereum's blockchain in small-scale projects. Some of the companies involved include Microsoft, JPMorgan Chase(NYSE:JPM), and MasterCard. Cryptocurrencies Ripple and IOTA have announced blockchain projects with brand-name companies recently as well.

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10. The barrier to entry is relatively low

It's also worth pointing out that while blockchain technology could change the landscape for the financial services industry, virtually no barrier to entry exists. If you have time, money, and a team that understands how to code, you can potentially write blockchain and bring a cryptocurrency to market.

How worrisome is this for kingpins like bitcoin and Ethereum? Back in July, there were fewer than 1,000 cryptocurrencies on the market. As of Dec. 18, there were 1,364. Anywhere from 50 to 100 new virtual currencies, likely complimented by blockchain technology, are being introduced each and every month. Each of these is another potential threat to existing virtual currencies and their blockchains.

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11. Institutional investors have stayed on the sidelines (until recently)

Though institutional investors usually make a market out of equities, and are instrumental in determining the "value" of publicly traded stocks, they've mostly kept to the sidelines with regard to digital currencies since they're an unregulated asset. This means the more emotionally charged retail investor has been behind most cryptocurrency trading to date.

But that's changing in a big way. Back on Dec. 10, CBOE Global Markets(NYSEMKT:CBOE) became the first to introduce bitcoin futures trading, with CME Group(NASDAQ:CME) following a week later. Futures trading gives institutional investors an easier means to place their bets on bitcoin. It also opens the door for investors to make money if bitcoin drops in value, which hadn't been possible prior to the listing of futures.

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12. Not everyone is a believer in virtual currencies

But as you might imagine, not everyone is onboard with the crypto-craze. Buy-and-hold investing mogul Warren Buffett noted in 2014 in an interview with CNBC that he believed bitcoin was a "mirage." Buffett commented that bitcoin amounted to nothing more than a means to transmit money, much in the same way a check does. "The idea that is has some huge intrinsic value is just a joke in my view," said Buffett.

Similarly, JPMorgan Chase CEO Jamie Dimon has referred to bitcoin as a "fraud" and "worse than tulip bulbs," which refers to the 17th century short-term bubble in tulip bulb prices in Europe. Dimon has gone on record as saying that bitcoin "won't end well."

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13. Cryptocurrencies are banned in a number of countries

Sure, cryptocurrencies might be the hottest thing since sliced bread, but they're not accepted everywhere. Because of their unregulated and decentralized nature, some countries have chosen to outright ban the use of, and/or trading of, digital currencies.

Trading in cryptocurrencies, making payments in virtual currencies, or buying goods and services in digital currencies, are illegal in a half-dozen countries: Bolivia, Bangladesh, Nepal, Morocco, Kyrgyzstan, and Ecuador. And there's the genuine possibility that this list may grow. For example, Russia has been considering banning payments made in cryptocurrencies for some time.

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14. Investors have a long history of overestimating the uptake of new technology

Another fact worth noting is that investors almost always overestimate how quickly new technology will be accepted by big business. Over the past two decades, we've witnessed investors push the valuations of internet companies, business-to-business commerce companies, 3D printing companies, and genome decoding biotech stocks, through the roof, only to have these bubbles burst a short time later. This isn't to say these industries failed, so much as to point out that they didn't match up to investors' lofty expectations right away.

With cryptocurrencies, we have an aggregate market cap up more than 2,100% since the year began, along with the belief that blockchain will be readily integrated by big businesses. If those businesses don't welcome blockchain with open arms immediately, we could witness yet another precedent of a bubble bursting.

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15. Most people still have limited knowledge of what cryptocurrencies are, or if they're legal

Truth be told, most folks don't have the slightest clue of what makes cryptocurrencies tick. Though a September poll conducted by student loan refinancing market LendEDU found that nearly 79% of Americans were aware of bitcoin, a more recent poll found that just 32% were aware of Ethereum, the second-largest cryptocurrency by market cap. Additionally, 75% of folks had never heard of initial coin offerings, which are akin to initial public offerings, but for virtual currencies.

Perhaps even scarier, LendEDU asked respondents if owning bitcoin was illegal in the U.S. Some 41.6% correctly answered that it wasn't, but 10.7% believed it was, and a whopping 47.7% weren't sure. This suggests a major lack of understanding when it comes to cryptocurrencies .

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16. Uncle Sam still wants his fair share

Last, but not least, don't assume that just because cryptocurrencies are unregulated, you're getting a free ride on any profits you pocket. The Internal Revenue Service (IRS) still expects you to pay tax on your cryptocurrency profits, and it's doing everything in its power to make sure that happens.

In late November, the IRS won a court case against Coinbase, one of the largest cryptocurrency trading platforms, requiring Coinbase to turn over identifying information on more than 14,300 users who'd had more than $20,000 in annual transactions between 2013 and 2015. This is noteworthy because only 800 to 900 taxpayers reported gains to the IRS between 2013 and 2015, suggesting that most users have knowingly sidestepped reporting their gains. Always remember, Uncle Sam gets his fair share!

Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Mastercard and Nvidia. The Motley Fool recommends Cboe Global Markets and CME Group. The Motley Fool has a disclosure policy.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong